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No Shortcuts to Investment Success (Part 2)

Beating the market is great if you can do it, but it's not a requisite for investment success.

Alex Bryan, CFA 11/04/19
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In part 1, we talked about our investment philosophy. Let’s continue to explore the journey to investment success.

Focus on What You Can Control

Beating the market is great if you can do it, but it's not a requisite for investment success. It's actually pretty far down the list of things to worry about. Even the best investment strategies can go through lengthy stretches of underperformance, and there's usually not much you can do about it. It's far more important to focus on things you can control: fees, tax efficiency, diversification, the amount of risk in your portfolio, and your behavior.

Successful investing starts with risk management. Never take more risk than you are comfortable with--and don't trust your first instinct here. It's easy to think you're more risk-tolerant than you are when everything has been going up for a long time, only to regret it after the market turns. So, before you load up on stocks, think back to your behavior during the last market downturn. If you sold out of your stock positions only to rebuild them during the subsequent rally, it might be worth considering a more conservative portfolio. This can be accomplished by shifting assets to bonds from stocks or tilting toward more-defensive stocks and bonds.

Whatever risk-management strategy you adopt, it's important to stick with it. Without that anchor, it's tempting to take too little risk in bad times after prices have fallen and too much risk when times are good. That is easier said than done. Uncertainty is a constant. The best defense is to prepare for bad times before they come and diversify. This will make it easier to stay invested and enjoy the benefits of compounding.

What to Expect

We take the long view and avoid making market calls, as that is very difficult to consistently get right (and the costs of being wrong can be substantial). That means we won't tell you to get out of long-term bonds when rates are going up. Instead, we might highlight the risk and point out some of the better options to mitigate it.

This long-term focus also means that the investment ideas we like won't change very often. While it's tempting to react to market news, it's rarely prudent to make big changes to a portfolio based on changes in market conditions. That's counterintuitive, and it's a view I didn't have six years ago. But the more I learn, the more convinced I become that the best course of action is often to do nothing. By the time you hear about what the Federal Reserve is doing, the impact of tariffs, or most other news bites, the horse has already gotten out of the barn--market prices prob­ably already reflect that information. It's hard to improve performance by acting on information that everyone else already knows.

Take a look at Exhibit 1. Acting on those types of big headlines probably wouldn't have helped your long-term performance. The day's news rarely has an impact on long-term returns. The most important drivers of long-term returns are interest rates and the amount of compensation investors require to take risk. Prices reflect the market's best assessment of what the future holds, but of course, no one knows for sure. News is unpredictable. If things turn out better than expected, risky assets like stocks should outperform; if not, they will probably offer disappointing returns. Over the long term, positive and negative surprises tend to wash out, leaving diversified risk-takers with reasonable compensation for their courage.

This doesn't mean that tactical adjustments are off the table. Sometimes risk-taking, and risk-taking in specific areas of the market, is rewarded. Valuations matter. But if you do make tactical adjustments, it's best to be systematic about it, focusing on things that matter, like valuations and momentum.

About Author Alex Bryan, CFA

Alex Bryan, CFA  

Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.